Many families provide formal methods to offer shareholders options for liquidity or exit. Such opportunities often actually strengthen family commitment to the business because the decision to remain an owner becomes a free choice and concerns for financial security are lessened.
Liquidity plans can take two approaches: (1) provide a total exit for shareholders wanting out or (2) provide money for those who want to remain shareholders but also seek some personal funds. Either approach, or a combination of the two, should be determined as part of the family business’s shareholder agreement.
Total exit is covered by a buy-sell agreement, which specifies how price will be determined and the terms for payment. We usually recommend a formula for valuation and payout terms that assure the continuity of the business. After all, most of the family will remain shareholders, the shareholding was often originally a gift and the owning family feels a commitment to protect the other interested parties (i.e., employees, the community and future generations of family owners).
Typical valuation formulas are tied to past profits and/or book value. Terms of payout typically range from three to ten years, secured by an interest-paying note, with conditions that limit payouts in case of company cash flow problems. The selling shareholder does not retain a voting role, but may receive a provision that boosts the payout if the business were to be sold in the near future (i.e. within the next three to five years).
More complicated are the means to provide partial liquidity – the ability to sell some, but not all, of one’s shareholdings. The key issue is how a partial sale of shares would affect the family’s harmony and governance structure. For example, if one person sold half of his shares, would he still have a full vote at the Family Council? Or, would he still receive all the same benefits (i.e., shareholder meeting expenses) as those who held all their shares?
Eventually the family may become large enough and the shares dispersed enough that this issue doesn’t matter. In those circumstances, one share increasingly gets one vote, dividends are paid and people cover their own expenses for shareholder activities.
If the family is large, as in the latter circumstance, the corporation can make an occasional general offer to redeem shares. A certain amount of money is put aside for this purpose and sales are accepted pro rata to one’s holdings. (This buyback event cannot occur regularly or often without causing significant tax disadvantages). In other cases, family businesses “make a market” in company shares by attempting to connect potential buyers and sellers within the family. Still others maintain a standing redemption fund, standing ready to make occasional purchases at a price and terms already established. Family businesses taking these approaches work closely with their advisors to avoid triggering tax problems.
Dividends or distributions are a more common way to provide shareholder liquidity. For older, larger families, this often serves the purpose. The drawback, of course, is that everyone must get the dividends whether they want them or not, the business’ retention of capital for growth is compromised and tax costs may be high.
Another common liquidity plan is to allow shareholders to borrow against their shares. The corporation establishes the arrangement with a bank and guarantees the loans.
The clear advantage of this approach is that shareholders don’t have to relinquish their ownership position, and the corporation usually doesn’t have to come up with money. The disadvantage is that the borrower can get overextended and the corporation can be forced to put up the guarantee. Too often, borrowers lack plans to save the money to pay off the loan or its interest. Then the corporation may be put on an unplanned spot. To lessen these risks, some such liquidity plans guarantee only about 50% of the value of the shares.
Other methods for liquidity are: (1) taking the business public, (2) having a standby buyer (family or otherwise) in case someone wants to sell, (3) creating an employee stock ownership plan (ESOP) and (4) forming a family trust fund that addresses individual needs (i.e., health care, house purchase, etc.). These methods are quite rare.
Providing a liquidity mechanism is an important step for assuring long-term family business continuity, harmonious family relations and personal freedom and responsibility. Which approach to take depends on the values of the family, the size of the family, the governance system for the family and the strength of the business.